Budget Reform Math: Tax Breaks = Government Spending

Budget Reform Math: Tax Breaks = Government Spending


I’m no more innumerate than the next financial journalist, but when hungry, I still prefer a snack that is 98 percent fat free to one that is 2 percent solid cholesterol. And if I’m sick, I’ll take a medicine that has a 20 percent chance of working over one known to be ineffective 80 percent of the time. I can’t help but be swayed by the framing of choices, even when I know the choice is an illusion. You can’t either.  It’s the way our brains work.

Unfortunately, it’s also how the budget debate is working. In budgetary arithmetic, there is no difference between a dollar of spending and a dollar of tax breaks, and the political purpose of the two is identical—to reward certain politically favored behavior and discourage the opposite.  But on the floor of Congress and on the campaign trail, the difference between a tax dollar spent and tax dollar not collected is fundamental.  The former is bad, the latter is good. Take a look at two separate subsidies for motherhood: When delivered as a government check, it is a handout, and recipients are known as “welfare mothers.”  When delivered as a tax credit, the same subsidy is tax relief, and recipients are known as “mothers.”

Harvard Law professor turned Treasury tax official Stanley Surrey coined the term “tax expenditure” to level the rhetorical playing field between government goodies delivered as deductions, credits, or tax deferrals and those delivered as checks. But rhetorically—and cognitively—it’s still not a fair fight.  Government spending still feels like an intrusion. Tax breaks feel like a blessing, and Republicans in particular have built their public message around that false distinction. That’s too bad: Individual and corporate tax expenditures now cost the U.S. Treasury more than a trillion dollars a year and account for a third to a quarter of all government benefits and subsidies — without being subject to annual appropriations review.  Once a tax break is in the tax code, it continues until specifically excised.

What’s worse, tax expenditures tend to be a particularly ineffective way to spend a trillion of the taxpayers’ dollars, especially when delivered as a tax deduction. Take, for example, the second largest tax expenditure (after the deductibility of employer-provided health care): the home mortgage deduction. Jason Fichtner, a senior research fellow at the Mercatus center at George Mason University, describes how the much-beloved tax break (which the OMB estimates will cost $98.5 billion in 2012) goes wrong:

The deductibility of mortgage interest ... provides an incentive for people to own, rather than rent, under the theory that…people are more likely to care and invest in the community ... if they are home owners ....[But its] design as a tax deduction provides perverse incentives and might not actually help those who really need help. For example, [it] encourages larger mortgages and larger homes than a family might buy without the deduction. Further, it’s worth more to higher income taxpayers because the deduction is offset against higher marginal tax rates, while for those in lower tax brackets the deduction is worth less or nothing at all for people who don’t itemize.

Specifically, while about two-thirds of American households own homes, only about a quarter of taxpayers take the home mortgage deduction—either because they don’t have a mortgage, or because they don’t itemize deductions.  Although a number of retirees with limited incomes may have benefitted from the deduction and have paid off their mortgages, running this subsidy through the tax code assures that this $98.5 billion addition to the budget deficit mainly benefits families in the top tax brackets living in the poshest  homes in America. If Congress were actually to appropriate $98.5 billion in funds to promote community feeling, you’d have to believe they’d find a more effective way to do it.

The worst thing about the framing of tax expenditures is that it forces Republicans to regard any attempt to rein them in as a tax hike — which, of course, they are sworn to oppose. The closest the Republican “Path to Prosperity” deficit reduction plan comes to addressing tax expenditures is to fold them into a still vague tax reform promise in which “loopholes and deductions” would be reduced in return for lower tax rates. That’s fine as far as it goes. But as Eric Todor, an economist with the Tax Policy Center at the Urban Institute points out, “The most egregious tax expenditures are the small ones that favor, say, bow-and-arrow makers or hedge fund managers. But the most expensive ones are those that benefit millions, like the home mortgage deduction and the one for health insurance.” It will be no easy feat, he says, to get millions of taxpayers to give those up as part of tax reform. That may simply be one reform too far.  

There may be one other way, however. Economist Martin Feldstein in a New York Times Op Ed last week suggested limiting tax deductions to 2% of a taxpayers’ adjusted gross income.  (The President’s deficit reduction plan would also impose a limit on deductions, but it would apply only to high income taxpayers.) Congress could avoid the bruising tax-break-by-tax-break fight needed to close out most expenditures, as envisioned in standard reform programs, and some Republicans could embrace the plan because it would allow greater revenue without raising marginal tax rates.

Before that is possible, however, the question has to be reframed. Lawmakers have to concede that tax credits, deductions, tax deferrals and preferential rates are not the opposite of government spending.  They are, as Feldstein puts it, “government spending by another name.” Any serious deficit plan must put them on the table.

Related Links:
High Earner’s take of Tax Expenditures Proportional to Tax Liability (The Hill) 
Capping Tax Expenditures: The Right Solution for the Wrong Reasons (The Atlantic)
Wonkbook: Boehner’s Debt-Ceiling Demands (Washington Post)